Thriving in volatile markets

Grant Watson and Saliegh Salaam, co-heads of the Quantitative Investments (QI) boutique at OMIGSA, say that they have found a way of delivering alpha at dramatically reduced volatility. Their managed volatility strategy was pioneered in South Africa by

What is the managed volatility strategy?
Watson explains, ‘We like to use the analogy of a person walking a dog along a beach. The person will walk a fairly straight line and cover less ground to get to the end of the beach, while the dog will zigzag up and down and cover much more ground to get the destination. The person is the MVF and the wild and erratic movements of the dog represent the market. Essentially, we offer our investors a much smoother ride without compromising on returns.’

How is this achieved? Importantly, QI boutique is not in the business of stock picking and there is no tactical opportunism in their approach to portfolio construction. ‘Just the opposite in fact,’ says Watson. ‘A key premise of our strategy is that low-risk portfolios outperform higher risk portfolios over long periods of time. Our aim is to construct lower risk portfolios, but make no use of derivatives or fundamental stock picking.’

During the construction phase, their focus is on the entire portfolio rather than o¬n individual shares. Risk is included upfront in that they have an ex-ante approach to risk management, whereas most of their competitors have an ex-post approach to risk management.

‘We evaluate the quality of the risk and the sensitivity to a range of risk factors, and always end up with a portfolio with materially less risk, as measured by volatility, than the benchmark,’ he continues.

Even though risk is a key component of their strategy, it is still unusual to hear an equity manager talking capital preservation. In fact, from an absolute perspective, you could even call them conservative equity managers.

Grant and Saliegh firmly subscribe to Warren Buffets’ first rule of investing which is: Never lose money. ‘You see’, says Salaam, if you make a loss, you need increased returns to recoup that loss before you actually start to see growth. Therefore, we are acutely aware of the dangers of losing money, even over the shorter term.’

Integral to the risk management of their portfolios is that they run a minimum variance portfolio that has a bias towards both value and momentum factors as a hedge against unfolding market conditions.

Performance advantages and disadvantages
A common criticism of some quantitative strategies is that they tend to unravel in periods of market stress or inflection points.
This is certainly not the case with the managed volatility strategy according to Salaam who says, ‘The managed volatility approach has proven highly resilient across a range of market conditions over the last two years, when markets have frequently swung from despair to euphoria within any one month.’

A look at the performance track record shows that when markets had a negative return, the fund had a 100% track record of outperforming its benchmark – i.e. not losing money relative to the SWIX.

When the SWIX had “normal”, moderate returns, the strategy o¬n average outperformed the market.

It is only when markets rose sharply – i.e. more than 6% in o¬ne month, that the strategy tends to underperform. Fortunately, the SWIX has o¬nly generated these kinds of abnormally high monthly returns 14% of the time since the inception of the index. In addition, these outperformance months are mitigated by the law of averages when the markets normalise.

There is no doubt that if the market turmoil of the past few years continues, as most expect it will, many institutional investors would welcome an equity investment solution that is designed specifically to provide a smoother return path than the benchmark, without sacrificing long-term returns.